Buy The Fear Like Buffett, 2 Bargains Yielding 7%

Co-produced with “Hidden Opportunities.”

Did you know what happened the day Warren Buffett bought his first stock? During the Berkshire Hathaway (BRK.A, BRK.B) annual shareholder meeting in 2018, The Oracle of Omaha held up a newspaper from March 12, 1942, and said it was the day he purchased his first stock. The paper was filled with bad news about World War II, and America appeared to be losing. The market dropped 2%, but our favorite investor consistently looks at the bigger picture while everyone is concentrating on today’s events.

In the short run, the market is a voting machine but in the long run, it is a weighing machine. – Warren Buffett in the 1987 Berkshire Hathaway Shareholder Letter

When markets behave like voting machines, they tend to ignore business fundamentals and are driven by speculation, sentiment, and other factors in the image. Today, everyone is concentrating on the inflation data, the Fed minutes, and the jobs report – data points that have been periodically released for decades but no one cared about until last year.

The more you are glued to the media coverage, the better their financial prospects and the less prudent your decision-making becomes. Stop making harmful short-term decisions due to the influence of the financial news. We have two picks with up to 7% yields for you to load up during this heightened fear and get paid to wait for the bigger picture to unfold.

Pick #1: MMP, Yield 7.8%

Restrictions on Russian crude oil imports and the G7’s price ceiling have caused the amount of U.S. crude oil exported to Europe (and China) to increase significantly in recent months. Enterprise Products Partners (EPD) management is bullish on the Permian basin output and predicts rising international demand for U.S. oil and gas in 2023.

We think a lot of crude oil has to come from this country to satisfy demand – Brent Secrest, COO, Enterprise Products Partners

Magellan Midstream Partners, L.P. (MMP) is a midstream Master Limited Partnership (“MLP”) that owns and operates assets to transport, store, and distribute petroleum products. MMP owns the country’s most extensive refined petroleum products pipeline system, with access to ~50% of the nation’s refining capacity and the infrastructure to store +100 million barrels of petroleum products such as gasoline, diesel fuel, and crude oil. Midstream assets form the backbone for U.S. energy exports, and MMP is well-positioned to see stable demand in 2023. (Source: Magellanlp.com.)

Note: MMP is a master limited partnership that issues a Schedule K-1 for tax purposes.

MMP’s Q4 results discussed elements that Warren Buffett will strongly approve of. The MLP said it would spend less on capital expenses, grow its distributable cash flow, and increase share buybacks and distributions to shareholders.

MMP reported a below-target 3.6x leverage ratio and a weighted average interest rate of 4.4%. All of MMP’s debt is at fixed rates, with no maturities until 2025. Most importantly, 83% of MMP’s long-term debt matures after 2030 (with a substantial portion maturing after 2042). We see significant flexibility with excess cash in the near term and efficient ways to increase shareholder value.

MMP has been aggressively pursuing share buybacks. Honestly, I am a lesser fan of buybacks and prefer cash in my pocket instead. However, in Q4, MMP bought 1.9 million units for $95 million, putting its total annual spend at $472 million. We don’t have access to MMP’s annual report yet, but as of Q3, MMP spent $30 million less YoY on distributions due to a substantial shrinkage in the shares outstanding.

We continue to see unit repurchases as an essential focus of our ongoing capital allocation efforts, and we continue to expect free cash flow after distributions to generally be used to repurchase our equity – Jeff Holman, CFO.

Mr. Buffett has repeatedly appreciated timely buybacks as meaningful initiatives to increase shareholder value.

When stock can be bought below a business’s value it is probably the best use of cash. – Warren Buffett, Berkshire Hathaway Annual Meeting (2004).

For long-term MMP investors, these buybacks represent better distribution coverage and healthy raises for the foreseeable future. MMP has issued a DCF guidance of $1.18 billion for 2023 (~4.5% higher YoY) and a distribution coverage of ~1.4x. This calculates to more than $215 million of FCF after distributions that can be used to reinvest in the business, buy back equity or otherwise create additional value for shareholders. MMP’s $1.0475 quarterly payments calculate a healthy 7.8% yield.

Global hydrocarbon demand is expected to see steady growth in the years ahead, and MMP presents an excellent value proposition to long-term income investors.

Pick #2: BTO, Yield 7%

U.S. banks reported their Q4 earnings last month, and while the industry is still preparing for a challenging economic environment, they appear to be more confident about moving forward. After all, Wall Street, Main Street, and my grandma expect a recession, so the nation’s biggest financial institutions are factoring this into their provisions. The six largest U.S. lenders are amassing a combined ~$5.7 billion in reserves to prepare for soured loans (more than double the $2.37 billion in 2022). Banks are pursuing less risky activities, and this caution is a positive for investors. Remember, loss provisions are anticipatory headwinds, whereas robust net interest income growth and net interest margin expansion are actually realized tailwinds from this rising rate environment.

Banking and financial services in the U.S. are highly regulated industries. Mr. Buffett is deeply familiar with this sector and has often said that the business is relatively straightforward and can be highly lucrative if managed well.

If you can just stay away from following the fads, and really making a lot of bad loans, banking has been a remarkably good business in this country – Warren Buffett, Berkshire Hathaway Annual Meeting (2003).

From time to time, this industry faces headwinds, as it did in 2008. At the time, Mr. Buffett went on a shopping spree and loaded up on JPMorgan (JPM), Goldman Sachs (GS), and Wells Fargo (WFC). Today’s recession fears are an opportunity for income investors to lock in attractive yields.

John Hancock Financial Opportunities Fund (BTO) is a Closed-End Fund (“CEF”) that invests primarily across the American banking sector. JHI is the U.S. subsidiary of the Canadian insurance giant Manulife (MFC). Source.

$10,000 invested in BTO in 2013 would have produced a handsome income stream of ~9.9% average annual yields. In 2022, BTO paid the bulk (85%) of those distributions using Net Investment Income (“NII”) and long-term capital gains. Source: Portfolio Visualizer

BTO is actively managed, and the fund uses interest rate swaps to hedge against rising rates. The majority of these contracts have their maturity dates going up to 2030, indicating that BTO is well-positioned to benefit till the end of the rate hike cycle.

The CEF has raised distributions several times since the Global Financial Crisis, including a healthy increase last year. BTO’s $0.65 quarterly distribution calculates to a healthy 7% annual yield.

In 2020, banks took a risk-averse stance and amassed massive loan loss provisions. These headwinds translated into huge tailwinds during the bull market, and investors collected healthy capital gains and growing dividends from the sector. With U.S. unemployment data still hovering at record low levels, the prospects of a job-full recession are strong. Remember, not all recessions are the same – the GFC may have hit the financial sector hard. However, today’s financial industry is better prepared to maintain lending through a brutal economic climate. BTO presents a quality CEF paying ~7% yields through diversified exposure from this cautious sector.

Conclusion

Warren Buffett has repeatedly advised investors to ignore the prophets of doom when times looked grim. During the worst periods of WWII in 1942, if an individual had courageously and mindfully invested $10,000 in the S&P 500 (SP500), their investment would be worth more than $50 million today.

I wasn’t worried because in a lifetime of participating in the American economy, it’s going to move forward dramatically over time, and it will have a lot of hiccups. – Warren Buffett on the 2008 Crisis.

Today, the U.S. economy is having hiccups, and the market is behaving like a voting machine. Readers may argue that what we see today is much more than a hiccup; trust me, that is what they said about every previous economic calamity. Bad news has people racing for the exits, but I plan to focus on building my income stream. I am using this fear to buy quality equities at deep discounts. Two picks with +7% yield to buy the fear like the wisest investor of all time.